Where is the ROI in an IT investment?
When considering an investment in IT, whether installation of a new system, or upgrade of an existing system, we need to understand how the investment is likely to perform. Of course, the project is being considered in order to enhance business workflow, but how do we evaluate the cost/benefit ratio? Estimating ROI (Return on Investment) is one way to demonstrate the relative value of the investment. This can help us understand whether the IT investment is a net income resource or a net expense. Some key questions that need to be answered to understand and use ROI to our advantage are as follows:
How do we measure ROI for an IT investment?
How do we identify and leverage the positive aspects of IT to ensure it bears a positive ROI?
In order to calculate the ROI, we must understand the terms in the equation.
ROI = (Gain from Investment – Cost of Investment) / Cost of Investment. Literally, the ROI calculation result is expressed as a percentage. The ROI can be annualized in order to compare to other investment options. Sometimes the ROI is reported as a net cash flow number.
Cost of Investment ≡ total cost to install and maintain the system; installation costs include cost of training. For a new system, where one previously does not exist, this is straightforward. For an upgrade or re-design, this is the cost to re-design or upgrade the system plus the difference in cost to maintain it vs. the cost to maintain the current system.
Gain from Investment ≡ reduction of operating costs comparing performance of the new system to the operating costs of the legacy system plus the increase in production efficiency directly related to operation of the new IT system. This will be consistent whether a new system installation or an upgrade is performed.
While the cost of investment can be accurately defined, it is more difficult to isolate the IT contribution of several factors contributing to the gain from investment. Let’s consider some of the factors that contribute to gains.
Reduction in operating costs can be based on measurable results, such as reduction in system downtime applied to the operating rate ($/hr). Limiting the gain on investment to downtime reduction is probably the easiest formula to defend, as this is a simple direct comparison of performance before after the IT investment is implemented, assuming no other significant factors changed along the way (e.g. change out of key personnel, etc.).
Considering the different input variables affecting the production efficiency gains (i.e. profit), we can perform a sensitivity analysis to understand which elements or variables can have the greatest impact, and focus efforts accordingly. This can be accomplished by forecasting gains for different scenarios, changing input variables one at a time, and observing the difference. This can be a useful tool for helping to choose business and IT strategy. Some factors to consider:
Inertia – Production rarely restarts at full rate after a downtime event. Similar to the laws of physics, inertia affects processes, and must be overcome to achieve your benchmark momentum. Therefore, the total cost of downtime is greater than the duration of downtime multiplied by the operating rate (or cost, e.g. $/hr). The cost savings from reduction of downtime frequency includes the reduction of production efficiency loss while re-starting the operation (i.e. overcoming inertia).
Increased Production Efficiency – With appropriate strategic planning and implementation, the new IT system (investment) should improve collaboration between different work groups, facilitating improved communication and cooperation, hence more streamlined workflow and improved overall production efficiency.
Employee Engagement and Motivation – Improvement in employee engagement and focus on primary job function should be expected when working with a stable IT system that is designed and operated in a manner that streamlines the workflow and makes it easier for the employee to achieve work output goals. When employees can see that the new tools and processes are helping them to be more productive, they get a morale boost, which tends to create additional performance gains.
The chart and data table below provide a hypothetical example. This example demonstrates how an IT investment can deliver a positive ROI. The variables can change according to the situation. Running the model for a range of different outcomes can provide insight into the potential value of investment, and can help your IT MSP and your company focus on the controllable variables that have the greatest impact.
In this example, the table below identifies the assumptions of changes to system performance and estimated costs for installing a new system. The only difference between the two new installation scenarios is that one system assumes no increase in steady state production rate and the other system shows in increase in steady state production rate. This comparison provides an understanding of the sensitivity of ROI based on production efficiency improvement brought on by the IT investment.
The light blue line in the chart above shows the net cash flow stream (profit) based on the system currently in use. Note there is no investment cost as reflected in the
$0 value at time zero.
The other two lines (grey and orange) show a starting value of -$385,000, which is the cost of the IT investment.
The grey line represents cumulative profit for the 1st calendar year after the IT upgrade is complete. This investment assumes reduction of downtime frequency (from 6/mo to 1/mo) plus an increase in steady state production rate (from 1500 widgets/mo to 1600 widgets/mo). Note that it crosses the blue line at about 5 ½ months. This is the point in time when the IT investment has paid out. Thereafter, the difference between the grey line and the blue line is the Gain from Investment.
The orange line represents cumulative profit for the 1st calendar year after the IT upgrade is complete. This investment assumes reduction of downtime frequency (from 6/mo to 1/mo) but no increase in steady state production rate (remains 1500/mo). Note that it crosses the blue line at about 9 months. This is the point in time when the IT investment has paid out. Thereafter, the difference between the orange line and the blue line is the Gain from Investment.
This chart shows the cumulative Gain from Investment for each of the two investment options. This is a direct measure of the difference in cumulative profit for each option compared to the base case (current system).
The numbers in the table above show the variables considered in the ROI determination. The Return on Investment is based on the annualized total Gain from Investment compared to the Cost of Investment, or (Gain from Investment – Cost of Investment) / Cost of Investment.
Realizing the ROI in Practice
The discussion and examples provided to this point are merely estimates of possible outcomes. Downtime and increase in production rate, assumed attributable to IT upgrade, were the only variables considered in the sensitivity analysis. A sensitivity analysis performed for other variables in a similar fashion can provide additional insight to the characteristics of the investment that have the most impact.
With an understanding of the ROI calculation, and how it can be used to forecast possible investment outcomes, we now need to consider HOW the Gains from Investment can be realized. How does IT contribute to those gains?
Let’s consider HOW application of Technology can contribute to downtime reduction. There are multiple ways that this can be accomplished. A few examples:
- Automation of Inventory Control: Continuous automated tracking of inventory levels of materials feeding a production line can be linked to notifications and even to automatic generation of POs, reducing the risk that the line is shut down due to lack of availability of inventory.
- Continuous Monitoring of Machinery Health Checks: Machines have moving parts, therefore are susceptible to wear and tear and drift. Continuous or periodic monitoring and reporting of the critical machine performance indicators allows for proactively adjusting the PM and/or calibration schedule to prevent manufacture of out of spec product. This reduces not only the downtime for extensive machine repair, it also eliminates waste of rejected product.
- Tracking of Production Schedule and Notification of QC Checks: Depending on contract terms, there may be requirements for stop or hold at certain points in the manufacture or assembly process, to allow a 3rd party inspection to be conducted before the product can proceed for further modification. These checks can be related to material chemistry, physical properties, dimensions, etc. Historically there are many instances of omitting the 3rd party verification or manufacturing shut downs when the 3rd party inspection service is not available at the time needed. Typically these problems can be overcome with adequate communication about production schedules. Having notifications automated based on production progress can eliminate the human error often to blame for the miscommunications or lack of notifications.
- Automated Verification Checks: One way to eliminate the problem of stoppages for QC checks is to implement methods for automated verification. For example, for dimensional checks, laser devices can provide precise measurements with no human intervention. This can eliminate the need for 3rd party inspection at this stage. The measurement data can be automatically recorded and occasional audits performed to ensure proper calibration of the laser equipment.
These examples (and many more) offer opportunity to reduce downtime, slowdown time, waste, and in general streamline the production line.
Consultation with an experienced and capable IT MSP can work with you to develop strategic solutions and to formulate tactical plans to enhance your business workflow, and realize POSITIVE ROI From Your IT Investments.